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What is the best country to set up a Securities Token Exchange?

Flag Theory Weekly Letter – Friday, January 11th, 2019

A few weeks ago we were discussing in this article why the crypto fundraising trend is turning from utility to securities tokens and why a tokenized securities market might be the key factor for institutional capital’s entry into the crypto space.

Securities tokens have certain challenges. One of the current challenges is the lack of liquidity. We’ve recently seen several projects from both established capital markets and crypto industry players, as well as other startups, aimed at building exchanges and infrastructure to trade digital securities. Eventually, we may see securities tokens attract secondary market investors and overcome the current liquidity issue.

Here at Flag Theory, we are continuously receiving inquiries on where would be the most suitable jurisdiction to set up a securities token exchange – and we’re working with a number of projects towards this purpose.

Building a securities exchange or brokerage platform may be a laborious endeavor. Capital markets are subject to comprehensive regulations and rules – which may also differ largely from jurisdiction to jurisdiction. While crypto is inherently international, securities rules are completely domestic.

Legal requirements, restrictions, obligations, and limitations may vary depending on the specific nature of the services provided, type of securities offered, type of targeted investors and their location, etc. One must seek out qualified legal advice for their specific business and various service providers before setting up a digital securities exchange.

We have compiled some jurisdictions below that entrepreneurs and businesses planning to launch a securities token exchange may consider to set up shop.

The following does not intend to be a comprehensive analysis on the licensing and ongoing requirements to operate a tokenized securities market and it does NOT constitute legal advice of any kind. It is just meant to be a quick overview of potential jurisdictions one can look at and some of the key aspects to take into account.

Cyprus Multilateral Trading Facility

Over the last few years, Cyprus has attracted a number of investment services firms targeting European Economic Area clients due to its relatively low tax regime (12.5% corporate tax), regulatory-friendly approach, quick licensing turnaround time, and low operating costs compared to some of its European neighbors.

On January 2018, the Investments Services and Activities and Regulated Markets Law of 2017 (Law 87(I)/2017) entered into force – transposing the European Markets in Financial Instruments Directive and Regulations (MiFID II/MiFIR) provisions into Cyprus law which aimed to increase market transparency and investor protection.

The new legislation provides stricter provisions and requirements on the competences and knowledge of officers involved in providing information to clients. It also set some changes on the ‘passporting’ regime – investment firms must now notify each Member State in which they are intending to provide services in addition to several new reporting and other requirements.

A Securities Token Exchange could seek authorization to the Cyprus Securities and Exchange Commission (CySEC) to operate as a Multilateral Trading Facility (MTF) and be regulated as a Market Operator and Cyprus Investment Firm (CIF).

Typically, an MTF would require paid-up capital of at least EUR 730,000. The head office must be situated in Cyprus and the company should have a significant physical presence and its mind and management on the island. Three of the required four directors may need to be residents and the company must maintain staff, premises, equipment, internal controls and compliance functions in Cyprus.

Professional indemnity insurance may be required – which should cover the whole territory of the European Union or some other comparable guarantee against liability arising from professional negligence, providing at least EUR 1,000,000, for a single claim, and on aggregate, at least EUR 1,500,000 per annum for all claims.

An MTF will be prohibited to execute client orders against proprietary capital or engaging in matched principal trading, in other words – you cannot trade your own book.

The intended Securities Token Exchange must satisfy the CySEC when it comes to adequate policies and procedures as well as appropriate rules governing the MTF – sound security mechanisms, sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, policies and procedures to prevent market abuse and conflicts of interest and compliance with AML/CFT regulations.

Outsourcing may be considerably restricted in order for the CySEC to monitor the MTF compliance with all its obligations. This means you can buy software but might need to run it in-house.

The CySEC will also evaluate whether the exchange has sufficient financial resources to operate the intended business according to its size and instruments offered.

The exchange must also have the appropriate risk disclosures and guidance on the instruments traded – taking into account the intended target market, whether retail or professional clients.

A Securities Token Exchange operating as an MTF may also apply to be registered as an SME growth market.

Issuers listed in an SME Growth market may enjoy certain regulatory relief such as an exemption from the requirement of producing insider lists, the possibility of posting inside information on the Exchange instead of the issuer’s own website or a simplified prospectus for secondary issuances.

As the name suggests, this is for small market enterprises, or, potentially, startups. To qualify as an SME Growth Market at least 50% of the issuers whose financial instruments are admitted to trading on the MTF need to be companies that had an average market capitalization of less than EUR 200 million for the previous three years.

There must be sufficient information published to enable investors to make an informed decision via either an appropriate admission document – or a prospectus if prospectus legislation is applicable in respect to a public offer being made in conjunction with the initial admission to trading.

The exchange must ensure that there is appropriate ongoing periodic financial reporting by or on behalf of an issuer on the market, for instance – audited annual reports.

Overall, Cyprus is a good option for those wanting access to the 500 million people across the European Economic Area. 

Let’s head from Cyprus to another sunny island, a few thousand kilometers away.

Singapore Recognized Market Operator

A Singaporean Exchange platform providing trading of tokens that are considered securities would be regulated by the Securities and Futures Act (SFA) and would need to be approved to operate as a Recognized Market Operator (RMO) by the Monetary Authority of Singapore (M.A.S). Alternatively, a company looking at launching a Securities Token Exchange might consider first seek temporary shelter under an umbrella known as the MAS Fintech Regulatory Sandbox.

Without sandbox approval, an exchange trading in securities will need to seek approval directly with the MAS for RMO status. RMOs are securities market operators that are not systemically important and provide services to non-retail investors.

There are currently 38 RMO operating in Singapore but only a few of them are domestic. These are small markets – most local RMOs are operating bond trading and commodity futures platforms to professional investors. However, a recently approved RMO has announced its plans to launch a securities token platform in the future.

An RMO incorporated in Singapore will be typically required to maintain a minimum base of liquid capital of at least SGD 500,000 and a financial buffer equivalent to six months of operating expenses.

RMOs have legal obligations to operate fair, orderly and transparent markets and are subject to compliance requirements and disclosures as set by the SFA. They are also obligated by various anti-money laundering regulations, guidelines on technology risk management and outsourcing, among other requirements, and additional obligations depending on the functions undertaken by each RMO on a case-by-case basis.

On May 2018, the MAS issued a consultation paper proposing to convert the current RMO regime to a 3-tiered regulatory framework. Each tier would have different levels of regulatory compliance conditions and requirements according to their systemic risk. This was done in order to provide more flexibility and attract companies innovating in the capital market space such as private companies and start-ups operating private markets, blockchain and p2p trading platforms.

Tier 3 RMO

The Tier 3 regime, which would be aimed at small operators that are targeting institutional investors and other capital market services licensees such as brokers or fund managers.

A Tier-3 RMO will enjoy streamlined admission requirements – applicants will only need to self-certify their compliance with regulations against a checklist of requirements prepared by MAS. This would considerably reduce the application process timeframe.

The minimum base capital would be reduced to SGD 50,000, the ongoing capital requirement will be reduced to three months of operating expenses and there will be a simplified set of requirements in relation to technology risk management and outsourcing.

Tier 3 RMO may only provide services to Capital Market Services Licensees and will not be allowed to provide direct access to any individuals, including accredited investors.

Individual accredited investors may only be able to participate in a securities market operated by an RMO Tier 3 via a Capital Market Services Licensee.

Tier 3 RMO business volume would be restricted to either SGD 10 million in revenue per year or SGD 10 billion in securities or derivatives contracts traded annually. If the exchange reaches these amounts, it would need to apply for a transition to an RMO Tier 2 status.

Tier 2 RMO

The RMO Tier 2 will be targeted to market operators that qualify under the current RMO regime. Current RMOs will be classified as Tier 2.

Tier 1 RMO

The RMO Tier 1 regime will be aimed at securities market operators that are targeting retail investors. A Tier 1 RMO will be subject to the same approval requirements as a Tier 2 RMO but it would be subject to higher regulatory and supervisory scrutiny by MAS.

A Tier 1 exchange would be required to place additional conduct safeguards to address retail investor protection. These might include a product governance framework, a prohibition from collecting or holding retail investors’ cash (non-deposit taking) or collateral (contributions in kind other than cash, i.e. ETH/BTC) or clearing and pre and post-trade transparency through the publication of bids and offers, price, volume and date of the last order or transaction for contracts or instruments offered.

If the exchange will be directly dealing with retail customers without brokers it will need to conduct a client suitability assessment, including the completion of a Customer Account Review and Customer Knowledge Assessment and obtain membership in a dispute resolution scheme listed under the MAS (Dispute Resolution Scheme) Regulations.

The exchange would be required to make sure that the securities tokens listed in the platform meet regulatory requirements such as prospectus requirements and provide access to such documents, monitor continuing disclosure obligations from issuers and change of control transactions such as takeovers and mergers.

Certain restrictions may be applied such as a cap of 200 Singapore resident retail investors per listed issuer and a maximum SGD 20,000 investment per investor. A Tier 1 RMO won’t be able to open more than 10,000 Singapore resident retail investor accounts.

While it’s understandable that MAS wants to protect Singapore retail investors and the proposed restrictions may seem stringent to some operators – bear the following in mind: there won’t be these same restrictions (20k SGD, 10k accounts) for serving overseas retail investors. But, when serving overseas retail investors – a Singapore-based Securities Token Exchange might be subject to capital markets regulations of the jurisdiction where the retail investor is located.

Implementing the aforementioned requirements may be technologically difficult in some regard (restricting certain members of the exchange to trade only certain accounts etc.) we might see a company seek an RMO license, but not allow Singapore retail customers.

Hong Kong Regulatory Sandbox

The Hong Kong Securities and Futures Commission (SFC) has launched a Regulatory Sandbox for automated trading platforms that enable trading of virtual assets considered securities and futures and sets out stringent requirements for these businesses to operate from Hong Kong.

A company looking at launching a Securities Token Exchange that is operated within Hong Kong or that offers services to Hong Kong residents would need to enter the Regulatory Sandbox and be licensed as a Platform Operator to deal in securities and provide automated trading services.

The sandbox is aimed at platforms which provide trading, clearing and settlement services for securities tokens and hold clients funds. Decentralized exchanges and platforms that offer trading of Bitcoin and other non-security assets are not eligible to enter the Sandbox.

The exchange will only be able to offer services to Professional Investors. Professional investors are generally individuals with a portfolio of at least HKD 8 million or corporations with a portfolio of not less than HKD 8 million or total assets of not less than HKD 40 million.

Other conditions apply such as the restriction of listing STO tokens at least 12 months after the STO or after the STO project has started to distribute profits; or transactions to be pre-funded and not allowing leverage or futures contracts or other derivative products.

How to apply for SFC STO Exchange Sandbox Status

Initially, Sandbox applicants will have to go through an exploratory stage where the SFC will assess whether the platform should be regulated by the SFC, risks, the ability of the virtual asset trading platform to comply with anti-money laundering standards and with the terms and conditions; investors’ interests; as well as local market and international regulatory developments.

This initial stage consists of submitting a Business Plan for the review of the SFC with the description of services that will be offered and the roles and functions of the Platform Operator, the hardware, software and technology used, the estimated trading volume and the type of assets traded and professional investors, AML policies, systems and procedures, and financial projections including fees and charges charged by the exchange, operating expenses and the financial position.

If the SFC makes a positive assessment, it would then consider granting a license to a qualified platform operator and it will then proceed to the next stage of the Sandbox which consists of several licensing conditions such as more frequent reporting, monitoring and reviews and more comprehensive internal controls closely supervised by the SFC compared to a  regular licensed entity.

After at least 12 months, the exchange may apply to the SFC for removal or changes of some licensing conditions and exit the Sandbox.

The Securities Token Exchange would need to have a Type 1 regulated activity license (dealing in securities) and a Type 7 regulated activity license (providing automated trading services). The minimum paid up capital required to obtain them is HKD 5 mil (USD 650,000) and liquid capital of HKD 3 mil (USD 380,000).

The company will need to be controlled and managed from and have a physical presence in Hong Kong and demonstrate adequate office premises to conduct the activity.

The Exchange will also be required to appoint two Responsible Officers (RO’s) who have been approved by the SFC – at least one must be an executive director.

Responsible Officers must have recognized industry qualifications, 3 years of financial markets industry experience, 2 years of proven company management skills and pass one of the recognized local regulatory framework papers.

In addition, any individual who carries on one or more regulated activities on behalf of the Exchange would be required to be approved as a licensed representative and possess the required academic qualification, industry experience and regulatory knowledge that satisfies the regulator.

The company will need to take out an insurance policy that fully covers all digital assets held in hot storage and a substantial coverage for those held in cold storage. It will need to prove that it has adequate compliance and money laundering reporting policies, systems and officers and internal controls to avoid employee conflicts of interests or market manipulation and abusive activities, trading rules and risks disclosures, among others.

Client’s assets will be required to be held in segregated accounts, regardless of whether they are securities or not. A certain threshold would be established to determine the amount of assets that should be held in cold storage.

A Securities Token Exchange will need to disclose the token listing criteria and consider other aspects such as the regulatory status of a virtual asset in relevant jurisdictions, its demand and supply, maturity, liquidity and its technical aspects. New assets listed would need to be reported to the SFC on a regular basis along with other information.

Additional or stringent terms and conditions may be imposed by the SFC on a case-by-case basis. For instance, the SFC may request that the Exchange maintain a reserve equivalent to a number of months of operating expenses as a financial buffer.

US Alternative Trading System

The United States is the jurisdiction that has seen the most movement in terms of Securities Token offerings – offerings typically targeting accredited investors via a private placement exemption under Reg D. However, there are other offerings such as Reg A+ which are also potentially viable.

The US has also seen a number of projects that have launched or are planning to launch Securities Token trading platforms or brokerages listing private placements for accredited investors.

A company planning to launch a Securities Token Exchange in the US would likely operate as an Alternative Trading System (ATS).

An ATS meets the definition of exchange under federal securities laws, however, it is not required to register as a national securities exchange and can operate under the exemptions available in the Exchange Act Rule 3a1-1(a). Note that an ATS can’t use in its name the word ‘exchange’, or derivations such as ‘stock market’.

An ATS must be a registered broker-dealer pursuant to the requirements in Rules 300-303 of Regulation of ATS and file an initial operation report with the SEC.

To register as a broker-dealer, a company must submit certain forms and new membership applications to the Financial Industry Regulatory Authority (FINRA), comply with all applicable requirements, describe its business and compliance policies, procedures and controls and the operation of the intended trading platform and ensure that all its officers are qualified. The company would require to become a member of at least one self-regulatory organization (SRO) such as FINRA, and also become a member of the Securities Investor Protection Corporation (SIPC).

Once the company has been approved as a registered Broker-Dealer it must notify the SEC of its intention to operate an ATS and make mandatory disclosures via Form ATS-N. This notification includes information about the company details, broker-dealer affiliates, as well as describing the type of targeted users, type of securities and operational procedures, among others.

If the SEC approves the trading platform it will be listed on the SEC website and the company will be able to start its trading platform operations.

An ATS has certain ongoing compliance requirements which include quarterly financial reports and other notifications of operational changes, among others.

In addition, an ATS will be subject to certain requirements such as maintaining an AML program, following certain marketing/information disclosure guidelines, complying with the Department of Treasury’s Office of Foreign Assets Control (OFAC) directives, conduct periodic capacity stress tests or review security/vulnerability of its systems, as well as establishing adequate contingency plans, among others.

An ATS will also need to maintain an adequate liquid core of capital pursuant to the Net Capital Rule (Rule 15c3 1) for broker/dealers. A broker/dealer will be required to have enough liquid assets to satisfy claims of customers if it goes out of business.

Note that an ATS must ensure that financial instruments listed in the platform meet regulatory requirements and are only available for trading to suitable investors. For instance, a security token issued under Reg D would only be available for Accredited Investors and must respect certain holding periods.

In addition, there could be certain additional state regulations to comply with depending on where your ATS is operated from.

If the trading platform also supports Bitcoin – it might also need to register as a Money Service Business (MSB) with the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN). MSB licensing is quite challenging as notoriously, one would have to seek approval in nearly all 50 states.

Without having registered as an MSB, the company could be in violations of 18 U.S.C. § 1960 which makes it a crime to operate a money transmitter business without an appropriate license in a particular State, and without having registered with FinCEN as an MSB under 31 U.S.C. § 5330.

The Bottom Line

As seen above, operating a securities token market demands following a complex set of rules and regulations and complying with stringent licensing and ongoing requirements.

Besides the legal and technical challenges that these platforms are facing to be compliant in order to start operations, in many jurisdictions, there is no regulatory experience when it comes to tokenized securities trading platforms which may increase the difficulty of the licensing process. Securities regulations were not enacted considering the specific characteristics and technological advances that come from tokenized asset trading platforms.

Flag Theory, together with our legal counsel & partners, can help you compare and navigate potential jurisdictions to decide where to set up your Securities Token Exchange considering your specific activities, type of securities offered for trading, targeted markets and investors, licensing and ongoing requirements, taxation, banking, financial resources, among others. Contact us, it will be a pleasure to assist you.